Bonds

Page written by AI. Reviewed internally on July 8, 2024.

Definition

Bonds are debt securities issued by governments, municipalities, corporations, and other entities to raise capital. When an investor buys a bond, they are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount at the bond’s maturity.

What is a bond?

Bonds are popular investment vehicles because they provide a relatively predictable stream of income in the form of interest payments and are often considered less volatile than stocks. They offer investors the opportunity to diversify their portfolios and manage risk, and they serve as a means for governments and companies to raise capital for various projects and operations.

Here are the key features of bonds:

Issuer: The entity that issues the bond, which can be a government, corporation, municipality, or other organisation.
Face value/par value: The initial value of the bond, which represents the amount the bondholder will receive when the bond matures.
Coupon rate: The annual interest rate that the bond pays, expressed as a percentage of the face value. This determines the amount of interest the bondholder will receive.
Maturity date: The date on which the bond reaches its full term and the issuer repays the bondholder the face value of the bond.
Interest payments: Bondholders receive periodic interest payments (known as coupons) based on the coupon rate and the face value of the bond. These payments are typically made semiannually.
Yield: The yield is the effective annual rate of return an investor can expect to earn from holding the bond until maturity, factoring in both the coupon payments and the bond’s purchase price.
Market price: Bonds can be traded in secondary markets, and their prices can fluctuate based on changes in interest rates, credit risk perception, and other market factors. The market price of a bond may be higher or lower than its face value.
Credit rating: Bonds are assigned credit ratings by credit rating agencies, reflecting the issuer’s creditworthiness and the level of risk associated with the bond. Higher-rated bonds are generally considered lower risk.

Types of bonds

There are four different types of bonds sold in the market. These are:

Corporate bonds: Companies issue corporate bonds instead of seeking bank loans for debt financing because bond markets typically offer more favourable terms and lower interest rates.
Municipal bonds: These are issued by the government. Some bonds provide tax-free coupon income for investors.
Government bonds: Bonds issued by the UK government are categorised based on their maturity. Those with a year or less are called “bills,” those with one to ten years are called “notes,” and those with more than ten years are called “bonds.”
Agency bonds: Bonds issued by government-affiliated organisations are considered agency bonds.

Example of bond

An investor named Sarah decides to buy a these government bonds.

Terms of the bond:
- Sarah pays £1,000 to the government to purchase the bond. The bond has a maturity period of 10 years.
- The coupon rate of 5% means that Sarah will receive annual interest payments of £50
Interest payments:
- Over the next 10 years, Sarah receives annual interest payments of £50 from the government.
Maturity:
- After 10 years, the bond matures. The government returns the original principal amount of £1,000 to Sarah.
Total return:
- Throughout the bond’s life, Sarah has received a total of £500 in interest payments plus the return of the principal amount, resulting in a total return of £1,500.